The annoyingly anonymous WSJ economics blog (one assumes it’s Greg Ip, but
can never be sure) talked
to Richmond Fed president Jeffrey Lacker yesterday, and asked him about
this year’s Nobel Prize in Economics. In response, he made an interesting distinction:
Mr. Lacker says mechanism design theory suggests “it’s not clear
that liquidity was an important constraint” in causing the recent turmoil
in financial markets. Rather, it suggests that the problem was more a shortage
of information, a conclusion he deemed “consistent with the lack of
use we’ve seen in the discount window,” the way the Fed lends
directly to bank.
Now Lacker can say this partly because there’s no consensus on what exactly
this curious animal called "liquidity" really is. In a narrow sense,
it just means "cash" – and so yes, if an absence of liquidity
is just the failure of banks to be able to borrow cash at any interest rate,
then what we saw this summer was not a liquidity crisis. (Quite the opposite,
in fact: the Fed funds rate dropped all the way to zero more than once.)
On the other hand, it’s fair to say that all markets are markets in information,
and that a shortage of information really is a shortage of liquidity
in the sense that liquidity is whatever it is that lubricates markets and makes
them transparent and efficient.
Now cutting overnight interest rates is not going to magically inject more
information into the system: the idea is that it’s more of a signal to the markets,
and an attempt to strengthen that diaphanous creature known as "confidence".
It is these second-order effects of rate cuts which are always, in the short
term, much more important than the first-order effects on narrowly-defined liquidity.